Contracting processes fall into two general types: 1) contracting processes are provided by a third party separate from the counterparties or 2) contracting processes are provided by counterparties directly to each other. The first case is often seen in exchanges that provide standardized contracts and processes, and often full novation, to the parties of a contract. The second case is most usually seen in direct bilateral contracting (e.g. in the over-the-counter market), and in contract exchanges that provide negotiation facilities, but not contract assurance. In the second case, insurance companies have designed insurance contracts that provide a partial measure of protection against the failure of a party to perform its obligations.
An exchange is a facility engaged in the business of facilitating the structuring, negotiation, execution, clearing, and settlement of contracts among it members. An exchange may be composed of one or more markets that segment contract categories, products, and members. Examples of exchanges include, but are not limited to, futures and options contract markets, electronic exchanges, automated procurement systems, automated order taking systems, structured contract marketing systems, and structured contract trading systems. A contract market is composed of the participants, facilities and rules by which offers and counteroffers can be made to structure, negotiate, execute, clear, and settle contracts. The over-the-counter market is a loosely interconnected plurality of exchanges, contract markets and participants. A member of an exchange is a legal entity authorized by an exchange to utilize its facilities to structure, negotiate, execute, clear, and settle contracts. A participant is any user, member or other entity authorized to use any facility of the exchange or its markets. Exchange rules are the terms and conditions required of members. Exchange rules may be specified and agreed by contract-between and among an exchange and its members, may be enforced by authorization procedures, and may be subject to government regulation. “Clear” means to provide assurance of contract performance to all counterparties to a contract that the terms of the contract will be performed, or that the money value of the contract will be paid in lieu of performance. “Execute” means to make an accepted offer enforceable on each counterparty that has agreed to the contract according to the exchange rules. “Settle” means to perform the obligations of each counterparty that is party to a contract, which may require financial transfers or physical product delivery. A central challenge of contracting has historically been assuring that the terms of executed contracts are performed. A method widely applied to assure performance has been the assignment of collateral to back the financial obligations of the counterparties. Collateral can be in the form of cash, securities, guarantees, contract portfolios, or letters of credit provided by a member to secure its contractual commitments. In some exchanges this collateral is called “margin”, and rules on net capital of exchange members provide further collateral. In bilateral contracting, collateral may take the form of net capital, a guarantee, an insurance contract, or pledged assets. In either case, the magnitude of collateral required might vary over time due to changing values of the contract, changing market conditions, the changing financial condition of the counterparties, and the progress of time toward expiration of the contracts. It has become common to use measures of financial risk to judge the appropriate magnitude of collateral. For example, margin levels in organized exchanges are often set based on historical or forecasted financial risk analyses.
Increasingly, the concept of value at risk (VaR) has been used to provide a consistent framework within which to measure financial risk of a contract as it changes over time, and to set collateral requirements based on a consistent confidence level. Value at risk is a quantitative measure of the amount by which the value of a portfolio of contracts may change over a specified time horizon at a specified confidence level, or quantitative index indicating likelihood. The computation of value at risk is described in multiple references and books in the literature. Three general categories of algorithms are described: historical, parametric, and simulation. Historical methods utilize a historically representative data set to project how a contract would have changed in value during that period of time. Parametric methods utilize analytically tractable formulas to represent the probability distribution for potential changes in a contract's value, and the parameters are then estimated using historical data and judgment. Simulation methods represent the time evolution of risk factors and contingent decisions over time, and combine the results. Risk factors may be market prices, default potential, external events, or other uncertainty. Scenarios can be created by random, pseudo-random, lattice, decision tree, or other methods. Probability distributions for the time evolution of the risk factors may be continuous or discrete, jointly dependent, and/or stochastic processes. The results may be combined by a simple average method, by weighting methods, or by other methods that aggregate scenarios. Each method has advantages. Historical methods enable representative past events to be used as a stress test for extreme changes in a contract's value. Parametric methods enable fast computation of contract value and value at risk for large portfolios, because the parametric methods are usually chosen for their analytic tractability. Simulation methods are generally more accurate than parametric, since no constraint on the nature of the underlying distribution of price changes or creditworthiness is required. Each method also has disadvantages. Historical methods are limited to the events that actually occurred in the past, rather than events that could occur. Parametric methods generally lose accuracy due to the assumptions imposed to produce tractable formulas. These assumptions may include the nature of the stochastic price process, the parametric form of the probability distribution of price changes, the parametric form of the probability distribution on volatility, the nature of optimal exercise of American options, the method of calculating indexes, and similar features of contracts that involve both rights and obligations. Simulation methods are time consuming to finish the computations, and with large multi-factor portfolios, the number of scenarios required can be very large to achieve a desired level of accuracy.
Recent literature has sought to more consistently apply value at risk to exchange trading. Indeed, the methods used by some exchanges to set contract margin levels can be viewed as being similar to applying value at risk methods. And, when used in procurement and marketing, VaR is a useful technique for measuring the credit risk posed by a prospective counterparty. A challenge in implementing value at risk as a measure of financial exposure when transactions are time critical is that the accurate computation of VaR is time intensive. While many approximations are available, permitting faster execution, their accuracy may be less than adequate.
To avoid risk-based computations during time-critical contracting, present approaches usually rely on a contract specific collateral, guarantee, or margin. Despite the potential that margins can be changed periodically, these methods do not enable an exchange to maintain a constant target level of financial risk since both price risk and counterparty default risks are continuously changing. A typical exchange margin system operates on a contract-specific basis, with potential cross-contract credits. These typical systems also do not enable full risk-based netting. “Netting” refers to an offset of one contract or risk against an equivalent and opposite contract element or risk. Similar observations apply to contract guarantees, letters of credit, and insurance contracts when they are used to assure contract performance.